Does section 7 of the Income tax Act form part of your annual tax planning?

Everyone, both individuals and companies need to do effective tax planning on at least an annual basis. Effective tax planning means paying taxes at the most optimal tax rates and this is only possible through the taxing of profits in the hands of the legal entities and individuals with the lowest marginal tax rates.

Unfortunately there are also the illegal ways to move profits and these movements are called tax avoidance schemes. Section 7 was inserted into the tax legislation many years ago to tackle specific tax avoiding schemes. The acknowledgement of section is crucial when tax planning is being done, to ensure you do not fall into an unplanned trap, causing unplanned taxes to be paid. Section 7 is specifically targeting assets which are donated by a taxpayer person to another person with the idea of avoiding tax in his own hands on the profits derived from these assets. Furthermore, for this section to apply the donator must still be alive at year-end and any interest-free loans may also be deemed to be donations.

The following are examples of specific scenarios of tax avoidance which is being targeted by section 7:

The taxpayer and founder of a trust donate a profit-making investment to his trust and at year-end the trustees of the trust distribute the profits from this investment to his minor child, being in the lower tax bracket than himself. This way he avoids being taxed on these profits in his personal capacity, being at a higher marginal rate. This scenario is specifically dealt with in section 7(3). The taxpayer will be taxed in his own hands on these profits and not the minor child.

The taxpayer transfers an investment to his spouse, being a house-wife for example, and let her rather be taxed on the profits of this investment. He saves the donations tax, since donations between spouses are exempt from donations tax and his wife pays the tax at a lower marginal tax rate. Section 7(2) specifically deems these profits to be taxed in the hands of the taxpayer and not in the hands of his wife

The taxpayer transfers an investment to his minor children. He pays the donations tax (if the donation exceeds R100,000) but the child is taxed at a lower tax rate. Again, section 7(3) deems these profits to be taxed in the hands of the taxpayer.

The taxpayer transfers an investment to a child on any other person living and working overseas and being a non-resident for tax purposes. He does not pay taxes on his foreign income in South Africa, but only on his South African investments. This person will most probably be taxed at a lower marginal tax rate in South Africa. Section 7(8) deems this income to be taxable in the hands of the taxpayer.

The taxpayer donates a profit-making investment to his trust and at year-end the trustees of the trust distribute the profits from this investment to a beneficiary who works and lives overseas, being a non-resident. Again, this scenario is specifically dealt with in section 7(8). The taxpayer will be taxed in his own hands on these profits and not the non-resident beneficiary.

The taxpayer donates an investment to his trust and decides not to distribute the profits to the beneficiaries but to rather retain the profits within the trust. Section 7(5) deems these profits to be taxable in the hands of the taxpayer and not in the trust.

The taxpayer holds and investment, but he cedes the profits of this investment to someone else. Section 7(7) deems these profits to be taxable in the hands of the taxpayer.

The abovementioned examples are obviously the most common, but there may be other scenario’s which must be carefully considered before going into action takes place. The main questions each taxpayer needs to ask himself with every transaction is:

Am I donating this asset?

To who am I donating this asset?

Who will be taxed on the profits deriving from this asset?

If the taxpayer knows the answers to both the abovementioned questions he is busy with effective tax planning and may he proceed with his transaction if he still wishes to.